Tony Yarrow, portfolio manager of the TB Wise Multi-Asset Income fund, explains why ‘tortoise stocks’ could deliver the goods in 2019.
As the stockmarket’s super-speedy growth hares roll over, something small, with a dark shape and domed top, is slowly approaching – a tortoise. Finally, it looks as if all the forgotten “tortoise stocks” that investors gave up on years ago, have started catching up as market conditions change.
Aesop's tale is a useful one for long-term investors. In the fable, a tortoise challenges a hare to a race. The hare dashes off and is soon far ahead, while the tortoise is nowhere to be seen. The day is hot, and the hare decides that there’s plenty of time for a rest. Waking up from a pleasant nap, it sees the tortoise crossing the winning line.
This ancient story speaks to today’s value versus growth dynamic – where the valuation chasm between the two styles has grown to historical extremes.
The recent growth stock sell-off has been unsettling for investors attracted by growth’s momentum. Growth sectors have been safe havens from the various squalls that have hit financial markets since the end of the crisis. Now, they are falling faster than anything else, while some value segments are seeing an upturn. The tortoise is catching the hares napping.
Slowly wins the race
We believe that winning the marathon of long-term investing depends on avoiding the many pitfalls that can lead to permanent loss of capital. These include balance-sheet risk, business risk, execution risk, poor management and over-valuation. Having excluded everything that seems uninvestable, we are left with the stocks that we consider good value and that have a compelling long-term business case – for us, these are the tortoise stocks.
The reason that the hares have been able to outstrip the tortoises is rooted in the financial crisis. Since then, investors continue to show a marked preference for assets that performed relatively well during the crisis, avoiding ones that did not. Investors prefer “defensive” companies, whose products and services remain in demand during a recession, such as pharmaceuticals, to “cyclical” ones, such as housebuilders.
Since 2008, investors have also preferred companies that do not borrow money to those that do, and “quality” companies, which can make higher margins on their sales, to others that make lower margins. The premium that investors are prepared to pay for these superior assets has continued to grow over the decade and is now unusually wide.
Growth at any price
Indeed, since the crisis, investors have been prepared to pay almost anything for growth stocks – companies able to grow their earnings faster than the underlying economy. It is often said that during times of low economic growth, it makes sense to pay a premium for the rare assets that can grow faster. We owned a number of these companies in TB Wise Multi-Asset Income, but prices shot up to a level well above our estimate of fair value, so we were forced to sell these stocks in the middle of 2017.
One example is Renishaw, a specialist manufacturer based in Wotton-under-Edge, and one of the UK’s undoubtedly world-class companies. We bought Renishaw in early 2016, paying about £16 per share. A year later, we sold the shares for about £25, but we sold them too early. By July this year, they had more than doubled to £57.50. At the time of writing, four months later, they are at £36.60, down more than 35% from their peak, and apparently in freefall. There has been a bubble in growth shares, and in today’s sell-off, they are falling the fastest.
Most investors, in our view, are momentum investors. It always feels good to buy something that has been going up, especially when respected experts are telling you why it will inevitably go up further… and then it does. There is nothing wrong with this, until eventually momentum assets take on a life of their own, and prices outstrip any reasonable estimate of underlying value. Even then, momentum can continue far longer than one could possibly imagine. The price chart tends to steepen until it rises almost vertically. This is the time of greatest risk, while feeling like a time of almost no risk.
Catching the hares napping
We believe that we are not in a bull market, but in a bear market that is already well established in many sectors, where it has, in our view, more or less run its course. In the final stages, which have just begun, the bear market has started to challenge sectors, such as growth – particularly in software and services – and “bond proxies” in sectors such as consumer staples and healthcare, which have been favourites over the past decade.
Value investors such as ourselves, who do not invest in growth or bond proxies because they are still significantly overvalued, can take comfort from the fact that the bear market has been going for a long time already. It will end as all bear markets do, and probably before all the things that we are worrying about – Brexit, trade wars, rising interest rates and so on – have ceased to be problematic.
All we need to do is stay calm and enjoy the generous and growing dividends our tortoise stocks pay us. The value we know exists will be realised in due course – when the steady tortoise finally passes the hare.
Tony Yarrow is portfolio manager of the TB Wise Multi-Asset Income fund.